Commentary

How to own Toyota Motor for free

Commentary: Auto maker should buy back its suppliers

By

BenWeiss

TEL AVIV (MarketWatch) — In its 75-year-old corporate history, the Japanese automobile maker Toyota Motor has distinguished itself in a number of ways. Sure, it can count as its biggest fan Larry David, of “Seinfeld” and “Curb Your Enthusiasm” fame, who drives around L.A. in his trusty Prius, but it has also created some of the world’s biggest-selling car models, Corolla and Lexus, and is regularly named by Barron’s and Forbes as one of the most admired and respected global companies.

Reuters

Exhibition stand at Geneva Car Show in 2010.

Toyota Motor (7203)
TOYOF, -1.08%
also holds one title that is the envy of all its peers, including Apple: namely, that it has the world’s highest annual research-and-development budget — a staggering $12 billion per year, or more than $1.2 million an hour, almost five times the size of Apple’s and a few billion more than Microsoft spends.

Fueled by its brand-rebuilding exercise over the past few years, Toyota Motor announced on Friday that it is targeting a record 9.58 million vehicle sales in 2012, with plans to catapult it past the iconic General Motors
GM, +3.40%
For those investors wanting to ride the upside in one of the world’s leading car makers, investing through its sister company, Toyota Industries (6201)
TYIDF, +5.13%
is a way to get into the driver’s seat for free.

Opening the door to investing in Toyota Motor

World's largest automakers

NAME

TICKER

UNITS SOLD

% GLOBAL SHARE

General Motors

GM

9.0 mln

12%

Volkswagen

DE:VOW

8.2 mln

11%

Toyota Motor

JP:7203

7.9 mln

10%

Ford Motor

F

5.3 mln

7%

Source: Company reports

The origins of the Toyota name date back to 1926 with the establishment by Sakichi Toyoda of Toyoda Industries, a manufacturer of textile looms. Eleven years later, Toyoda Industries spun out Toyota Motor as its automobile division, releasing its first Model AA car. (Note: The switch from “Toyoda” to “Toyota” came about due to the ease of pronunciation and in writing Japanese characters.) At its inception, Toyota adopted the keiretsu model, which later led to the creation of a dizzying array of contracts, relationships and cross-ownership across its family of companies.

These days, the child has outgrown the parent. Toyota Motor is now the $120 billion giant, with an astonishing $247 billion in global sales, and is the leader of the Toyota group of companies, which now spans car manufacturers Daihatsu and Fuji Heavy (owner of Subaru), truck makers Hino and Isuzu Motors, and motorcycle maker Yamaha Motor. Conversely, Toyota Industries, while still playing an important role producing Toyota-branded forklifts and manufacturing the Rav4 and Land Cruiser engines, has a market value of just $9 billion, only 8% of the size of its former subsidiary.

This keiretsu model has had its benefits for the Toyota companies — notably, protection and stability — but it has also been the scourge of corporate governance and shareholder activists. Looking under the hood of this corporate labyrinth, however, there exists a well-oiled investment opportunity.

How investors can get a ‘free’ ride in Toyota Motor

When Toyota Industries spun out Toyota Motor, it retained the single largest investment in the automobile maker. Seventy-five years later, Toyota Industries still owns 215.64 million shares in Toyota Motor, a 6.25% stake, valued at a little north of $8 billion — almost equal to its entire $9 billion market value.

Toyota Industries shareholdings

NAME

TICKER

stake

Value

Toyota Motor

JP:7203

6.25%

$8.191 mln

Denso Corp.

JP:6902

7.85%

$2.074 bln

Toyota Tsuho Corp.

JP:8015

11.12%

$742 mln

Aisin Seiki

JP:7259

7.03%

$657 mln

Others

$1.377 bln

Total investment portfolio

$13.020 bln

Toyota Industries market value

$9.253 bln

Source: MarketWatch, Bloomberg, company reports

In fact, the Toyota Industries investment tank is even larger, at a total of $13 billion, and includes a $2 billion stake in Toyota components maker Denso (6902) and a $740 million holding in trading company Toyota Tsusho (8015).

Buttressed by its $8 billion holding in Toyota Motor stock, investors can buy into Toyota Industries and essentially get a free ride on any upside in Toyota Motor. Moreover, at current prices, Toyota Industries trades at a 23% discount to its net asset value and spins off an annual 2.2% dividend yield. And, what’s more, there remains the tantalizing prospect of a merger between the two companies.

Time to rev up shareholder value in Toyota

With the ghost of the 2009 vehicle recalls almost behind it, and with Toyota Motor needing more than ever to lift its poor-performing stock (down 60% in five years), the company has turned its attention to rebuilding value for its shareholders.

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A positive first step was to raise its dividend 11% in March last year. Since then, however, natural disasters in Japan (tsunami) and Thailand (floods), together with a strong yen, have taken a bite out of profit margins, so there is urgency for the board to be more creative.

Taking the lead from the recent decisions of Coca-Cola and PepsiCo to start buying back some of their bottling operations, it may be time for Toyota Motor to consider privatizing its own supply-chain companies. In the front seat should be Toyota Industries. If Toyota Motor were to acquire the remaining 75.2% in the parts maker it doesn’t already own, it could send its earnings per share up 10% overnight.

I have prepared the operator’s manual for the Toyota board. Toyota Motor pays ¥3,000 for every Toyota Industries share — a 30% premium and in line with its book value. Toyota Motor then consolidates the remaining 75.2% into its own P&L and adjusts for the costs of financing the takeover and the loss of dividend and equity income from unwinding the cross-ownership. Next, cancel and move to treasury stock the 216 million shares owned by Toyota Industries, reducing its share count by 7%. Yatta (Japanese for “Bingo”), the combination leads to a 10% upgrade in earnings per share for Toyota Motor shareholders. The naysayers may point to the burdensome costs of financing the $9 billion takeover as it would push the automobile maker to a near 100% debt-to-equity ratio. However, Toyota Motor has unused credit lines of $97 billion and maintains one of the highest corporate credit ratings, so it has capacity to borrow, and at rates lower than most sovereign governments.

Operator's manual to Toyota acquisition

+/-

+Net profit Toyota Motor

$5.35 bln

+Net profit Toyota Industries

$0.47 bln

-Consolidation adjustments

($0.34 bln)

Pro forma Toyota Motor

Net profit

$5.47 bln

2%

Shares outstanding

2.92 bln

7%

Earnings per share

$1.87

10%

Net debt

$125.7 bln

-7%

Net debt/equity

93%

-7%

Source: MarketWatch, Reuters

So with such simple, straightforward mechanics, why have the Toyota boards not acted on this? In reality, there have been few examples (if any) of Japanese companies bending to the will of shareholders to dismantle the engines of these historical keiretsu relationships.

In the land of the rising sun, preserving traditions and relationships often take priority over shareholder interests, throwing a spanner in the works for those looking to create value. However, the recent decision by Toyota Motor in July 2011 to buy out two of its subsidiary companies (Toyota Auto Body and Kanto Auto Works) may suggest a subtle turning of the tide and, possibly, a review of its entire operations may be under consideration.

Time to start your engines?

As the great business thinker Peter Drucker once said, “Behind every success, someone once made a courageous decision.” Today there are a few savvy U.S. fund managers — Third Avenue and Harris Associates, to name two — sitting on the register of Toyota Industries, patiently waiting for Toyota Motor to turn its M&A key. And if recent announcements from the Toyota board are anything to go by, the automobile maker has reignited its corporate mojo.

Time, perhaps, for investors also to reignite their own interest in Toyota.

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